Debts to Keep, Debts to Pay Off
Do you have a debt strategy? Before you start laughing and say, "Sure, my strategy is to borrow more," hear me out. Debts can add to your net worth, just as investments can. But you have to be smart. Some loans are worth keeping, even enlarging, if you use the proceeds well. Others waste money or are downright risky.
Some people can’t wait to get rid of their mortgage. So they add extra money to their payment every month. The faster the loan is reduced, the less total interest is owed to the bank. But what’s the hurry? If you’re young or middle-aged, it’s far more important to put the maximum into your retirement plan at work. If you work for yourself put the maximum into a Keogh or SEP-IRA plan. With a house plus financial investments, you’re better diversified.
During the past 30 years, the Standard & Poor’s 500 have earned an average of nearly 14 percent annually, according to Ibbotson Associates in Chicago. Long-term investors have a good shot at earning more money in their stock-owning mutual funds than they can save by paying their mortgages ahead of time. You might have a change of heart, however, when you retire. At that point, your monthly income will probably drop, making a mortgage harder to carry. At that point you can use some of your investment gains to pay off the bank.
How about borrowing against your house to invest in stocks? A home-equity loan is a second mortgage that you can tap at will for anything you want. At this writing, home-equity loans cost anywhere from 8 percent to 12 percent, depending on the lender. Those are variable rates, so they might rise. The more your loan costs, the greater the change that you won’t earn enough in stocks to make the risk worthwhile.
Best advice: Save your home-equity borrowing for other things—for example, home improvements, major home repairs, or college tuition (the interest is deductible if you itemize on your return). You might also use a home-equity loan to pay off higher-cost credit card debt — but only if you truly intend to control your spending. Do not borrow against your home to consolidate your debt if you’re likely to run up your credit cards all over again.
Many young people today get out of school with a lot of debt. Usually, they want to pay it off as fast as they can. But student loans cost no more than 8.25 percent in interest. What's more, during the first five years that you repay, the interest may be tax deductible up to $2,000. (This tax break is for singles with adjusted gross incomes up to $40,000, phasing out at $55,000, and couples filing jointly, with combined incomes up to $60,000, phasing out at $75,000). In general, you’re better off putting some money into savings rather than speeding up repayments of student debt. You might even consolidate your loans and stretch out the payment,s if that frees up the money you need for a 401(k). You can prepay your student loan whenever you want --- say, when you get a little richer.
Loans against your 401k:
Are you thinking of borrowing against your retirement plan and putting the money into stocks? Forget about it! You already own stocks if you have stock-owning mutual funds in your 401(k). And, in your plan, your market gains are tax-deferred. If you want extra stocks outside your plan, buy them with "play money" – not with long-term retirement money that you’ve invested for your future.
What if you need the money for some other purpose? The interest rate on a 401(k) loan is currently around 9.25 percent. For cars, a dealer auto loan is cheaper. For education, it’s better to choose a student loan or parent loan (federal PLUS loans for parents cost 9 percent or less.)
It’s cheaper to take out a 401(k) loan than to borrow against your credit cards, but it’s unwise to tap your retirement money to finance current consumer spending. Typically, you repay 401(k) loans over five years. But if you lose or leave your job, you may have to repay the balance immediately. If you can’t, the amount still owed is treated as a withdrawal. You’ll owe taxes on it, plus a 10 percent penalty if you’re younger than 59½.
Loans against an IRA:
Sorry, not allowed. You can withdraw up to $10,000, penalty–free, to buy your first home, but it’s not a loan. Your IRA simply becomes $10,000 smaller. To me, that’s a reasonable use of IRA funds. Owning a home is as valuable as having a retirement plan.
Credit Card Debt:
There’s nothing useful about consumer debt that’s rolled over each month. Try plastic surgery: Cut up cards you can’t control. Then set up a plan for paying off everything.